Tax Implications & Relief
When a foreclosure occurs, there are two possible tax liabilities that might fall upon a homeowner. The first would be due to forgiven debt, which tax law treats as income, and the second tax liability would come from capital gains. In almost all cases, there is relief available for homeowners with primary residences that have gone into foreclosure, but if the home is non-primary, such as a second home, a vacation home or an investment property, the tax burden can be heavy.
Income from Debt Forgiveness
With the Mortgage Forgiveness Debt Relief Act of 2007, debt forgiveness on a mortgage loan is no longer a taxable event on primary residences if it was in connection with a mortgage restructuring or in relation to a foreclosure. Additionally, the discharge of debt must be associated with a drop in the value of the home or due to a taxpayer’s distressed finances in order for the Act to apply. There is a cap at $2 million, or$1 million if married and filing separately, on the amount of mortgage debt forgiven in any particular year between 2007 through 2012.
The Act requires not only that the loan be on a primary residence to qualify for the exclusion, but that the loan must have been for buying, building or improving the residence. So loans that were refinanced to pay off additional debts, like credit cards or car loans, or to pull cash out for any reason, do not qualify. Vacation, investment properties and second homes also don’t qualify under this Act.
The Internal Revenue Service provides further information and examples under Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
Capital Gains from a Foreclosure Sale
A foreclosure may not appear to be a sale to a homeowner since they probably wouldn’t see any income from it, but under the tax code, a foreclosure is considered a sale, and therefore subject to capital gains taxes.
Capital gains tax on a home is simply calculated as the sale price minus the original purchase price, also referred to as the basis or adjusted basis. When a foreclosure takes place, the transfer of ownership from the homeowner to the lender is treated as a “sale.” The sale price then is not the amount that the home is “sold” for, but rather it is determined differently and even then further dictated by the type of mortgage, either recourse or nonrecourse. For recourse loans, the sale price is simply the fair market value of the home. On nonrecourse loans, the sale price is the greater of either the fair market value or the amount of the mortgage owed on the home.
If the foreclosed-upon homeowner has lived in the home as his primary residence for two out of the last five years, then he/she is eligible for the home sale gain exclusion which allows up to $250,000 in profit to be excluded from taxes, or up to $500,000 for married couples filing jointly. Put more simply, a homeowner would not have to pay capital gains tax on any gain below $250,000 (or $500,000) as long as they fit the criteria mentioned. If the capital gains were to exceed those limits, taxes would be collected at the 15 percent (or 5 percent for low income taxpayers) capital gains rate.
Tax Relief
Besides the already mentioned Mortgage Forgiveness Debt Relief Act of 2007 and the home sale gain exclusion, there are two other circumstances that can offer tax relief.
If a homeowner can prove insolvency, the inability to meet debt obligations, before the mortgage is discharged and also afterward, then the proceeds from the “sale” or turnover will not be taxed. Proving insolvency can be tricky though because there is no clear definition of what assets can be used in the calculation.
The other circumstance that can offer some tax relief is bankruptcy, whereby any debts that are forgiven through the bankruptcy are not taxed. Bankruptcy is a complicated process and there are many pros and cons that should be weighed out with a law professional before deciding whether it makes sense for your individual situation.
Next Step…
Examine the home-saving solutions available to homeowners who are facing foreclosure.
